October 2, 2026
The string of positive economic indicators continued this week as GDP growth for the first half of the year was revised upwards and third quarter growth seems likely to be even more robust. Is the Fed is supposed to worry about growth that is averaging 2.5%? Our answer is no. Productivity growth has accelerated which, in our opinion, has boosted the economy’s potential growth rate from 2.0% to 3.0%. If so, 2.5% GDP growth is a perfectly acceptable, noninflationary, pace. Further, barring a full scale return to fighting in the Mideast and sharply higher oil prices, the inflation rate should slide from its current 3.0% pace to something roughly in line with the Fed’s 2.0% target by the end of next year. The combination of subdued growth in the money supply, slow growth in wages, and a leveling off of home prices should finally converge and reduce the inflation rate to its desired pace. With near potential growth in the economy, and a slowing to a near target inflation rate, the Fed should not have to go very far along the path towards higher interest rates. We anticipate one final 0.25% hike in the funds rate in December to 4.0-4.25% and no further action in 2027. We are well aware that market participants are currently worried about everything – accelerating GDP growth which could push the inflation rate higher, renewed fighting in Iran which would boost oil prices, and a series of Fed rate hikes that could push the economy over the edge into recession. But we see things differently – near potential GDP growth, an inflation rate that slows to the 2.0% mark, and the need for only minor tinkering with the funds rate in the months ahead. What’s not to like?
This past week with more complete data in hand the BEA revised upwards GDP growth for the first quarter of the year to 2.5% (from 2.1%) and lifted second quarter growth to 2.2% (from 1.5%). Growth for the third quarter data will not be released until the end of this month but it is shaping up at about 3.5%. If that is correct, growth for the first three quarters of this year will average 2.7%. Given that the Fed still believes the economy’s potential growth rate is 2.0% will it be concerned about steady growth well in excess of the economy’s speed limit? We doubt it.
Fed Chair Warsh has repeatedly noted that AI has boosted productivity growth. In the past three years productivity growth has averaged 2.5%. In the 10-year period prior to the 2020 recession productivity growth averaged 1.2%. It seems clear to us that AI has done exactly what it was supposed to do – boost productivity. And given that the implementation of AI is still in its infancy, we anticipate 2.5% growth in productivity for years to come. Combining that with 0.5% growth in the labor force suggests that the economy’s potential growth rate has climbed from 2.0% previously to 3.0%. If that is the case, the Fed should not be alarmed if growth averages 2.7%. Instead of fighting it, the Fed should welcome the faster rate of growth.
One might correctly note that the Fed’s problem at the moment is the inflation rate. The core personal consumption expenditures deflator has risen 3.0% in the past year. That is not even close to the Fed’s 2.0% target. Barring the resumption of full scale fighting in Iran, we would suggest that there are a number of factors that will lower the inflation rate significantly in 2027.
First, money supply growth in the past year has averaged 5.7%. The excess liquidity the Fed created in the 2021-2022 period has been eliminated. That excess liquidity was the cause of the inflation surge in those years. Hence, the elimination of the excess liquidity should help bring the inflation rate back to its target.
Second, wage growth has been steadily slowing. As a result, unit labor costs (labor costs adjusted for the change in productivity) has slowed from 5.0% a couple of years ago to 1.4%. The Fed has a 2.0% inflation target. This means that, if anything, the labor market should generate some slight downward pressure on the inflation rate in 2027.
Finally, home prices have essentially flattened out. Given that rents seem to lag the change in home prices by about a year, the “shelter” component of the CPI, which is one-third of the entire index, should slow from 3.0% currently to 2.0% or so by the end of next year, and contribute to the overall slowdown in inflation
If all of that comes to pass, the core rate of inflation should approach the Fed’s 2.0% target by the end of 2027.
Rapid growth in the economy combined with a significant slowdown in the inflation rate should keep the Fed on the sidelines. Like virtually everybody else, we expect one additional rate hike in December to 4.0-4.25% and nothing further throughout 2027.
After a couple of rough years of letting the inflation rate get out of hand the Fed is back on track with a lot of help from AI along the way..
Stephen Slifer
NumberNomics
Charleston, S.C.
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